The sequence of returns risk (SORR), or sequencing risk, is the risk that you will be unlucky and have lousy returns while at the peak of your invested capital. That could lead to portfolio failure and hitting the Fancy Feast before your taste buds die. SORR risk is caused by cash flows into and out of a portfolio and is accentuated by volatility. We can manipulate these two variables to mitigate sequencing risk.
I previously reviewed some asset allocation strategies to mitigate SORR. Of course, that comes at a cost. Reducing the sequence of returns risk by stabilizing volatility using bonds also lowers the expected returns. Unfortunately, lower returns could also lead to running out of money. Further, for most people, behavioral risk is a more important driver than SORR when considering a portfolio’s bonds allocation.
This week, let’s look at the other way to mitigate SORR. Flexible Cash Flow.
Cash flow is what causes SORR.
Dollars invested are exposed to the returns that follow (missing the ones before) and dollars removed miss the future returns.
The biggest risk is that you need to take money out when the market is at the low of a major bear market and miss the ride back up. That lost capital doesn’t grow into the future and leaves you with less moving forward. So, it makes sense that if you can minimize taking money out in a bear market that you decrease the sequence of return risk.
A bear market bites hardest in the years right after retirement when your capital is at its greatest. A 30% drop for a $1M portfolio is $300K. Much more than if it were a $100K portfolio and a $30K drop. We spend actual dollars to live, so the change in absolute dollars is what matters.
Flexible cash flow mitigates SORR.
If we need a fixed amount of money from our portfolio to live off of, then we must take it out. Even if it is at a market low. We are at the mercy of the sequence of returns. On the other hand, if we can decrease our portfolio draw for that bad bear market year it mitigates the sequencing risk substantially.
Let’s use the same model as the previous posts on sequence of return risk. For the 30 year accumulation period, $25K/yr is invested. They then retire and draw $128K/yr for another 30 years before they die. They are unlucky and experience a 30% bear market in their first year of retirement. That would have them hitting the Fancy Feast for about 3 years before they hit the dirt. On the other hand, if they decreased their draw during that bad first year by 25% to $96K – then they would run out of money on their deathbed instead.
One year of moderately less cash withdrawal translated into 3 years of not being totally broke. That is a pretty powerful impact and shows that a minor course adjustment early on makes for a radically different destination.
So, how could they adjust to decrease their withdrawal rate for that year?
Spend less, earn something, or borrow temporarily. That sounds kind of trite. However, when we unpack it, I think that there are some interesting strategies to do this in practical terms.
Have some fat stores.
To do this, we need to plan to have some fat in our retirement budget. That is a problem for those who are planning to lean-FIRE with minimal discretionary spending on luxuries. Those planning to fatFIRE have some extra.. uh.. cushioning.
There are also periodic larger expenses that we may have some flexibility about when exactly to incur them. For example, a new vehicle, home renovation, or trip.
Use some of your human capital instead.
Money is used to exchange between time/effort/comfort (human capital) and our financial capital. If we are retired, we may have more time and energy to do things that we would otherwise pay for. Perhaps, do the home renovation yourself. Cook for yourself more. Build or fix things instead of paying someone else to. Besides the financial aspect, learning and using new skills helps with healthier aging. Doing this with family or friends, even more so. Preserve financial capital and build human capital at the same time.
Earning something using a Work Glide Path.
I actually think that this is likely one of the best options for the high-power professional. Instead of a glide path changing asset allocation into retirement, this is a glide path changing how we work into retirement. A “work glide path“. This not only attenuates sequence risk, but it also has other psychological benefits.
You may not need to earn much.
If you have a healthy fixed income allocation, then that is a source of money to tap. The amount you need to earn on top of that to bridge the spending gap may not be much. Also, many of our expenses in early retirement are likely to be less.
When working full time, we have all sorts of other expenses from working. They can be direct (like transportation) or indirect (like hiring a cleaner or ordering meals to make up for less available time/energy). Since we have arrived at our destination, the extra money required to fund RRSPs, TFSAs, or other retirement accounts is less or eliminated. Income taxes are also an expense of working. The taxes on the higher earned-income levels during our earning/saving years are usually much more than what we’d pay on the investment income from our portfolio.
Working has non-financial benefits.
Work feeds us in many ways. The right work in the right dosage feeds our need for activity, sense of purpose, sense of self, and our relationships.
Activity and Purpose.
There are some people who have sedentary passivity or napping as their super-power. However, most cannot just sit around or spend all of their time on leisure. They need a sense of purpose. That means that they are putting time/effort into something important. Most high-income professionals or successful business owners did not get that way through sloth. Purpose and activity are inherent parts of their lives and they’d be driven them nuts in their absence.
Sense of self.
One of the questions that Crispy Doc asks in his Docs Who Cut Back series is about how much of our identity is wrapped up in medicine. I think that it is much more than many of us are willing to admit. Even me. Medicine has been a huge part of most docs’ lives for many years and it is a rewarding and generally respected pursuit. It even changes our surname from the usual Mr/Mrs/Miss/Ms. I suspect that most career-oriented people have their careers form a significant part of their identity. They may experience loss and disorientation if they end that relationship abruptly, rather than phase it out.
The hospitals or other institutions that we work within won’t love us back. Having some emotional separation from them helps to stave off the bitterness of unrequited love. However, we do form many treasured relationships with the people at work. Colleagues, other co-workers, and patients. It is a major social outlet for many people. Again, weaning off of that while forming new relationships may be better than a quick divorce.
Work doesn’t have to be all or nothing.
Most high-income professionals, like doctors, have very valuable skills and experience. The personal cost sunk into honing them is one reason why many find it hard to move on. While they may not have the capacity or desire to use them fully as they age, they could make a very valuable contribution in a part-time, casual, or less demanding role. There are plenty of physician side hustles out there.
Borrowing temporarily to bridge a bad sequence of returns.
Another way to avoid drawing on a portfolio during a bear market is to borrow the money from somewhere else instead. That is functionally the same as leveraged investing. So, it needs very careful consideration before embarking upon this path.
Factors to consider before borrowing:
- What rate can you borrow at?
- Can you stomach the debt?
- Can you easily pay it back? Over what timeframe?
What rate can you borrow at and from where?
Interest rates in a downturn.
On the positive side of the equation is that if equities are tanking, the interest rates usually are too. Central banks use this lever to try to stimulate people to borrow money to spend and re-ignite the economy in a downturn. Rates will usually be lower than the long-term expected returns. I am not talking about credit cards and high-interest consumer loans. Those are never a good idea to carry. I am talking about a low-interest loan around the prime lending rate.
Of course, you need collateral to access a low-rate money.
Borrowing against falling assets like investment accounts or possibly real estate may not fly. Banks may be calling in loans made against investments in this environment. Margin loans and home equity loans (HELOC) are callable by the lender at any time. Margin loans tend to get called when markets crash – bad timing. For a HELOC, the psychology of borrowing against your house is very emotionally stimulating (in a negative way) and increases risk. Imagine you see your portfolio continue to drop and you have also borrowed against your house. The feeling that you may lose it all is not a good feeling.
Still, some with a lot of home equity and deep enough pockets to pay it off if needed, a home equity LOC may be an option. However, those are likely the same people who don’t really need to worry about sequencing risk anyway because they have lots of financial buffer.
For those with some whole life insurance, this might be one of the uses.
As stated elsewhere in the blog, for most people, whole or permanent life insurance is not a great investment vehicle. However, there are some people with large estates who could use some for estate planning or as a way to hold extra “fixed-income-like” assets in their corporation. Again, these are likely not people who need to worry about sequencing risk. However, if they have the policy anyway – borrowing against its cash value to decrease sequencing risk from an unlucky bear market may be a good option.
If using leverage, you need a plan.
This is vital. The mathematics of using leverage for long-term investment plans usually work out. However, leverage also magnifies the emotions that drive us to deviate from the plan and changing the math. Execution risk. To minimize that, you need a plan that factors in expected or probable events. Such as protracted bear markets.
Personally, I would plan to not exceed amounts of money that I could easily repay. It is less scary. I would need to know that “I will be ok no matter what” because there is a significant chance that I could see my investment accounts shrink further before they recover. If there were an unlucky market drawdown in my first year of retirement that triggered me to use leverage, then I would have no idea how deep it was going to go. ?30% ?40% ?50%. No idea. But, I would want to consider the worst-case scenario.
You would also need to consider over what time-frame that it would be easy to repay. As my Investin’ Intestinal Fortitude Testor exercise (mobile or tablet/desktop) illustrates, a bear market can last years, permeates our environment, and even our personal lives. I would want to factor that into my tolerance. I would plan on a loan that I could easily repay over a few years at most.
Flexible cash flow allows us to attenuate SORR by avoiding taking money out of our portfolio in an unlucky downturn during the period of highest risk (around retirement). A small change can have a large impact.
Using a “work glide path” around retirement to wean off of the non-financial benefits of work seems the best route for me. Others may prefer a different combination of spending less or earning income in an alternate way. Using debt as a temporary bridge may be possible for some. However, that comes with its own pitfalls and risks – especially for those for whom SORR risk is highest in the first place (those with limited financial flexibility and resources).